Costa Rica: Landmark fiscal reform bill signed into law on 3 December
December 21, 2018
A long-awaited fiscal reform bill was passed by the Legislative Assembly after a second reading on 3 December, becoming law the following day. The bill includes revenue-generating changes to Costa Rica’s tax regime and puts limits on government spending, following a significant deterioration of public finances in recent years. However, some analysts remain wary of whether the reform goes deep enough and are skeptical of government fiscal projections.
The government originally hoped to use the reform package to reduce the fiscal deficit by 1.9% of GDP, although several exemptions were introduced during the parliamentary revision process which have reduced the final estimated impact. Nevertheless, the deficit—which hit a multi-decade high of 6.2% of GDP in 2017 and is forecast to have risen further in 2018—should still be trimmed going forward thanks to this reform.
The reform bill swaps the old general tax on sales for a value-added tax with the same standard rate of 13%, while also incorporating reduced rates of 4%, 2% and 1% for selected goods and services. It limits government spending increases by setting fiscal rules linking spending to GDP growth as well as the public debt-to-GDP ratio. The bill also increases income tax rates for high-income earners and raises the capital gains tax in most cases. The government expects these measures to bring the fiscal deficit to below 4% of GDP by 2023; however, on 5 December Moody’s cast doubt on the achievability of this and reduced Costa Rica’s credit rating from Ba2 to B1 with a negative outlook. Moody’s explained that most of the forecast deficit reduction comes from limiting expenditures over time, which it believes will be difficult in an environment of popular opposition to austerity and headwinds to economic growth. Moreover, on 21 December S&P Global Ratings downgraded Costa Rica’s credit rating to B+ from BB- with a negative outlook for similar reasons. Meanwhile, FocusEconomics panelists appear broadly unconvinced that the government will succeed in markedly reducing the fiscal deficit, which they see remaining above 5.5% through 2023.
In terms of the broader economy, the new measures could weigh on private and government consumption in the near-term. However, there will likely be a boost to private fixed investment growth as businesses will have greater clarity for their long-term planning and more confidence in the governance of Costa Rica. The effect of the reform on inflation will likely be mixed: On the one hand, a greater range of goods and services being taxed should stoke price rises overall; on the other hand, weaker consumption growth should have the opposite effect. The colón, meanwhile, has strengthened slightly following the reform’s approval due to reduced uncertainty, although it could come under pressure again if the government notably fails to meet its fiscal targets.
Author: Edward Gardner, Economist